August Market Commentary

Commentary by QLO Advisors Ltd – A Thornbridge Appointed Representative

The economic outlook deteriorated further in August as soaring energy costs in Europe threaten to undermine consumer and business spending further going into winter. This comes on top of already negative real wages and faltering consumer spending. Against this backdrop, MSCI World declined 4%, and Europe performed marginally worse with a 5% drop in the broad Stoxx 600 index. German yields rose more than 70bps on renewed inflation fears, whilst in the US the rise in yields was a little over 50bps. Wavebreaker was up 0.3% in August with gains in the trend following strategy being largely offset by losses in the asset allocation strategy; mainly due to a long bond exposure.

We have been building a long global bond exposure since May (from a short position in Jan-Apr) on the expectation that global inflation was topping and that sufficient central bank tightening was already priced by the bond market. We have done so gradually, intending to reach a maximum exposure around year-end, when we anticipated (and still do) that we have deeper recessionary conditions and inflation will have peaked (globally).

Europe

The renewed energy shock in Europe, driven by rising natural gas prices, invalidates that view for Europe and pushes back the top in headline inflation here by a few months. It will also set the European inflation peak at a much higher level than anticipated just a month ago. Due to delays between power production and customer invoicing, the rising costs will only start to hit consumers in September. For Europe, an ‘island’ in terms of its relative isolation and dependence on Russia for natural gas import, the situation is highly fluid and could quickly either deteriorate or improve, depending on a few crucial and unpredictable factors like weather and restoration of US export facilities, as well as the speed of substitution efforts. What is clear is that large fiscal aid packages, at current power prices, are necessary to prevent a deep recession, and we expect a slew of announcements over the coming weeks to alleviate rising power costs. The most likely scenario is that consumers will absorb some of the rising costs, but with the government covering the bulk; partially offset by extraordinary taxation of low-cost energy producers. This does amount to a net fiscal easing, but contrary to the pandemic stimulus, this is unlikely to entirely offset the shock and still puts consumers in a worse situation compared to July. It does not help that the ECB will likely continue to hike rates in a futile effort to regain credibility and to prevent the long end from becoming unhinged. It will only further undermine the economy and we believe this will be a grave policy error, as there will be significant downward pressure on the economy in the coming months.

US

The US has not experienced the same energy shock in August due to its domestic production of gas. Despite higher employment, consumer spending in real terms has been running on fumes for the past six months as real income has been falling. Driven by a continued slowdown in housing, our US base case remains a (deeper) recession evolving over the next 9-12 months. This will not be helpful for Europe either.

At present we still like to be short equities (global) and long bonds (global) but we have halted our purchase of European bonds until the situation becomes clearer.